The other day I pointed out how stupid it was that they banned short-selling on various stocks. I could go into details, although many NY Times, WSJ and other articles have already covered this territory. But to just list a couple of issues-
1) Do you prevent people from writing (naked) calls or buying puts?
2) How do you deal with the fact that most financial firms routinely do paired long/short purchases as a hedging strategy (and in general this hasn’t been responsible at all for the issues lately).
3) How do you deal with the options market makers that routinely short stocks to hedge the short term risks as they write options? This issue is so serious that its rumored that the SEC is going to fix it on Monday and allow the options market makers to short stocks.
4) Why those 799 stocks and not others? How do I get my favorite stock on the list of ones that you aren’t allowed to short?
Its all just clear evidence that its a bone-headed rule given that its causes a huge mess in the normal functioning of the market and has tons of unintended consequences. If you need to shut down the markets for a day or two so people can cool off, fine.
I’ve got to say that my initial read on the proposed $700B bailout plan is that its a really bad idea too. What this is supposed to fix is that people are complaining that the market for these crappy mortgage securities is illiquid since they can’t find buyers for them. So the government is going to jump in and provide a buyer for these things. I’ve heard some interesting analysis (sorry, don’t have a link) that points out that they aren’t actually illiquid- there are buyers, but the people holding them now just don’t like the prices that the market would set for them. So rather than have the market set a fair price for these, the government comes in and buys them- but who the heck knows how the government is supposed to decide what an appropriate price is. The way its going to work is almost inevitably going to end up with a price much higher than would be fair (than the market would provide), this creating $100Bs of hand-outs to the people who created this mess in the first place.
I mentioned that I’m reading “When Genius Failed” about the failure of LTCM in 1998. I started reading this slowly a long time ago but recent events have me much more interested in it. Its amazing how similar everything is. There are two key themes that I see underlying both the book and current events in the financial industry.
First of all, lots of the mess happens because we accidentally encourage people to take more risks than they should. When a fund makes tons of extra money on gains (but doesn’t pay back losses presumably), and when many financial firms would bonus their traders in a similar way, it encourages really risky behavior since big short term wins can be a huge payoff. In a similar fashion, there are many instances of overall firms or the whole industry going down too risky ventures because they assume that if anything goes wrong there is going to be a bailout. This is what happened in 1998 when Russia was having all sorts of trouble- initially the G7 helped out and the market kept investing in wacky ways because they assumed that Russia (a nuclear superpower they kept pointing out) couldn’t be allowed to default. This $700B plan + what has happened for several other companies in the last couple of weeks will just long term reinforce that companies should go for it, as long as they can entangle themselves enough with other players so they can’t be allowed to fail.
The other key issue is transparency. Over and over part of the underlying problem is the ways that the financial companies have hidden what kind of deals they are really cutting, what their true leverage is (since many of the new derivatives contracts don’t even count at all), etc. Now the financial firms have often said that they should have the right to protect their secret strategies and proprietary trading. Sounds good in theory, but for better or worse they have proven to us that the impacts of their failures and poor risk management spread well beyond just penalizing the management of their companies.
Having criticized the measures in place right now I feel like I should offer a suggestion of what we could do. I’m not sure if its a good plan, but it does seem to have the one nice characteristic that probably just about every existing player in the financial industry will hate it equally.
The base principle is that the financial markets don’t exist just as arbitrary entities for their own self enrichment. That’s fine, but we have capital markets because they ideally provide our society with a very important function of providing capital needed for various activities (companies, municipal, government, etc), while providing a reasonable way for people to accumulate, preserve and protect their personal assets for retirement and life. The key mechanism of the market is ideally that it provide _fair_ prices for things, defined as what a buyer and seller would mutually agree to given access to reasonable information. Every specific from equities, bonds all the way to the strange derivatives just exist to re-enforce this. The strange derivatives can be really important- why not let someone trade a fixed interest rate in one currency for a floating rate in another one, if they want to reduce some business risk.
Given all the goals above, if you were going to create a new market, why not have a rule that 100% of all transactions need to be public. With modern computer systems you could have a flow of 100% of the billions of transactions that all go into the system and become accessible to anyone that wants to subscribe to the system (not necessarily for free, but at a reasonable cost that offsets just the expense of providing such a huge feed) on a 1 or 7 day delay. You can be free to pursue whatever strategies you want, but if you start shorting some company, you can’t quietly do it for weeks without anyone noticing. If you figured something out you get a reasonable head start on everyone else taking advantage of it and can probably make a nice profit, but probably not a huge windfall.
Meanwhile one of the things that LTCM did and seems to have happened again is that they did their business with tons of different firms to keep any other firm from getting a good view of what was going on. LTCM was leveraged 30-1 (50-1 later when they started suffering losses) but none of their partners could tell since they each had such a small view of what LTCM was doing. Its a very familiar pattern reading lots of analysis these past weeks. Firm A does a bunch of deals with all the other big firms around the industry, but because their partners don’t see the details or big picture, they don’t see how out on a limb Firm A really is and have know way of judging whether the transactions are reasonable risk or high risk. Then when Firm A collapses, it threatens to take down all its partners. If everyone else had seen what was really happening sooner, they would have had an opportunity to turn off the spigot before it got so bad.
I’m sure many folks in the industry would argue that they have the right to conduct their business strategies without their competitors watching. But for what its worth there are precedents that governments force companies to disclose things to the public, and this is hardly the first time when the current system has created huge bailouts (although I suspect its the first time the bill could hit $1T). Too much of the basic functioning of our society relies on these guys getting it right.
Furthermore the SEC has proven to have no teeth to enforce things via the existing system of regulation. So to be clear, this data needs to be made available to the public, not just the government. I don’t mean to imply that normal citizens will directly be able to use it, but there will be plenty of financial incentives to spot what kind of fishy stuff is going on and sell that information to interested parties (in effect similar to what the bond rating services do, but probably with much more real data).